Dividend Investing: Easily Beat the Market?

There is a nice tax advantage to purchasing Canadian companies in non-registered (Cash/Margin) accounts. Presumably to entice money flow into local stocks, the Government of Canada provides very favourable tax rates for Canadians receive dividends from shares in Canadian corporations.

This has led to a massive dividend investor following in Canada. Every so often a news article will come out declaring that any Canadian can earn $50,000 a year tax free... or something to that effect.

But should you join the party?

What are Dividends?

Dividends are basically payments made by companies to their shareholders, typically on a regular basis. It's basically profit-sharing—a way of visibly rewarding shareholders for their investment in the company.

Most companies pay dividends from their profits instead of re-investing those earnings back into the business. Therefore dividends are typically paid by established, slower growing corporations.

Some companies which are unprofitable pay dividends as well (with borrowed money). To be safe, dividend investors often look for companies with a healthy dividend payout ratio: where dividend payments per share are much lower than net earnings share.

Forms of Dividend Investing

The appeal of dividend growth investing appears very valid. Instead of focusing intently on company valuations (or blindly indexing), you purchase a portfolio of companies who reward their investors with a pattern of growing distributions and hold them forever. The historical returns of this strategy have been pretty good.

The iShares Canadian Dividend Aristocrats ETF (trades as CDZ.TO) is a good, broad measure for this strategy. It has returned 6.33% annually over the past ten years, solidly beating the broader index iShares TSX Capped Composite ETF (trades as XIC.TO) which returned just 4.49% annually in the same period.

Dividend income investing follows a slightly different logic. Investors choose larger companies with high yields, but filter for payout ratio safety. The best long-term ETF capturing this strategy is the iShares Canadian Select Dividend ETF (trades as XDV.TO) which returned 5.30% annually over the last decade. Again, it nicely outperformed XIC.TO.

A Bigger Picture

Dividend investors love to brag about the easy, passive dividend payments earned each month or quarter. But many ignore total returns, diversification, and valuations.

It's very common to see dedicated dividend investors concentrated in a few "old economy" sectors: financials, pipelines, utilities, telecoms, grocers, and REITs.

This strategy ignores some of the best performers on the Canadian market not noted for their dividends: Constellation Software, CGI Group, Shopify, Brookfield Asset Management, Canadian National, Canadian Pacific, and Fairfax Financial. You get all of these companies when you buy the broader Canadian market index. Their share of the broader index grows as the companies get larger.

While I can't argue about the past performance of these strategies compared to the overall Canadian index, I am skeptical of their future performance.

Future of Dividend Investing

One of my biggest qualms against pursuing this strategy is the inherent concentration is these so-called "safe sectors". These traditional sectors already form a large chunk of the broader Canadian stock market.

Since the financial crisis in 2008-2009, interest rates have been chopped and kept extremely low. This means "old economy", capital intensive industries have done very well as their borrowing costs dropped substantially.

This has prompted a huge increase in borrowing and fueled growth in assets and earnings per share. The loan growth benefits the big banks while the low interest costs allow for capital expansion.

In addition, the retail investing community still has a distrust of the stock market after two massive crashes in less than 10 years. When buying stocks in recent years, retail investors have gravitated to sectors which have been traditionally held for their stability: Canadian banks, utilities, grocers, etc. This is a big change from the 1990s when money dumped into wobbly tech stocks—causing massive overvaluation and a lot of investor pain (remember Nortel?).

However, as a result of this money pouring in, the value of these slower growing, capital intensive sectors has exploded beyond comprehension relative to their growth prospects.

Loblaws (trades as L.TO), the boring owner of Superstore and Shoppers Drug Mart, trades hands at a massive 31x last year's earnings! That's the same multiple given to fast-growing, capital light Google.

Another dividend favourite, Enbridge (trades as ENB.TO), is valued at a similar multiple of 29x. All it does is transport goop through a massive network of pipes while carrying $40B of growing debt on its books. Great when interest rates are low, but those are destined to go up at some point.

Our infallible banks are tied to the fat and happy Canadian housing market where young, impressionable, uneducated, and greedy buyers foolishly fight for wildly overpriced real estate they can't actually afford. The value of mortgages on our "safe" banks' books has rocketed higher with our housing boom. Mortgages which are not backed by CMHC have been growing substantially.

When house prices correct to historical norms the effects will be devastating. Seeing how the U.S. and Irish housing crashes impacted their banks, I can imagine what a correction will do to ours... if it happens.

I'm Not Dividend Investing

If you choose to be a dividend focused investor, be very mindful of the risks going forward with this strategy. With the value of dividend favourite "safe" sectors bid up so high, I have good reason to believe dividend investing is going to substantially underperform a Growth/Balanced Portfolio in the years ahead.

Personally I'm staying clear, instead looking at the entire global stock market, sectors that grow, and my total returns. Many wise investors get burned by lack of diversification—don't be one of them.

Comments & Questions

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In your SM account you need to buy investments that provide income. Canadian dividend income is the best choice because it’s the most tax efficient for most people employing the strategy. That said, I would generally stray from dividend focused investing (high yield or high divvy growth or some combination of these). The stocks praised by the dividend investing crowd are generally very expensive right now considering the growth prospects. To me it’s crazy when a grocery store chain is valued higher than Google on a P/E basis.
That said, there’s a lot of stocks which pay dividends, including the wider index. There’s nothing wrong with holding a Canadian index fund, or a basket of lower-yielding stocks (not favoured by divvy crowd), for your SM account and avoiding this overvaluation/low growth combination.
This article just points out the valuation issues with stocks loved by the divvy crowd. It’s not a strategy I’m willing to pursue given the facts.

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